Japanese government bonds have kept stumbling. Small beer anywhere else in the world, but considering the policy experiment ongoing over there it’s worth keeping an eye on.
We’re not too excited yet but here’s a chart of five and ten year yields and some speculation anyway…
Capital Economics suggest the jump in the yields of Japanese government bonds (JGBs) in the last few days probably reflects a confluence of many factors — including speculation that domestic institutions are set to step up their diversification into foreign bonds and local equities, rising yields in overseas markets, the correction of an earlier undershoot, and hopes that attempts to end deflation might actually work. As they note (with our emphasis):
In other words, the rise in JGB yields does not mean that the Bank of Japan’s policy is doomed to fail. To the extent that the increases reflect higher expectations for inflation, it might actually be deemed a sign of success, and the real interest rates that matter more for investment decisions and the public debt burden could still be lower than otherwise. We would be more concerned if JGB yields rose as a result of a surge in yields overseas, or a loss of credibility on fiscal policy. But we expect US yields to remain low and assume, for now at least, that the Abe government will press ahead with the increases in the consumption tax planned for 2014 and 2015. In these circumstances, and especially if the equity rally runs out of steam too, 10-year JGB yields should still average less than 1.0% this year and next.
Fair enough. If we start to see a weaker Nikkei and a stronger yen while yields keep heading up, maybe we should get worried. But right now it seems yields are rising as policy goals are met and as what might be termed ‘normal’ financial conditions return.
The rally in reasonably thinly-traded inflation-linked bonds tells its own story, but it’s worth pointing out, as Citi’s Steve Englander does, that inflation expectations reflect a scheduled doubling of the sales tax in 2014/15 to 10 per cent, so it is the recent run-up that is of interest, not the level, which is somewhat artificial.
Englander adds that although higher inflation expectations will not make the Japanese economy structurally better, BoJ-enforced lower real rates will encourage Japanese investors to pull money from the JGB market (presumably replaced by BoJ buying) and encourage investment in other asset markets both domestically and abroad.
The combination will tend to reduce the real value of Japanese government debt, which could be a get-out-of-jail-free card for Japanese policymakers. Bottom line is that they have plenty of incentives to encourage continuation of higher inflation expectations and JPY will weaken organically as this happens, without explicit JPY selling by the MoF/BoJ.
Anyway, here’s a little bit more of a proper warning, from Bank of New York Mellon’s Simon Derrick to keep everyone alert:
Given the sheer scale of the JGB market (the MOF estimated in January that there would be JPY 749.6 Trn of outstanding JGBs by the end of March), officials will no doubt be concerned that this move could extend into something rather messier (indeed, finance minister Aso, vice finance minister Obuchi and economy minister Amari all discussed JGBs today). In particular, although yields are still low when considered against where they were at the start of the financial crisis, officials will be aware that the last time a major reversal emerged in the JGB market (back in June 2003), the yield on the benchmark 10-year bond jumped from below 0.5% to above 1.6% in the space of just 3 months. They will also no doubt recall that during that time they were engaged in an aggressive campaign to stop USD/JPY falling below a “line in the sand” around the JPY 115 level (this defence ultimately collapsed in the September of that year following a G7 meeting in Dubai). Looking further back it is also worth recalling that in the six months after the LTCM crisis of 1998 10-year yields spiked from just above 0.6% to well above 2.2%. Tellingly, USD/JPY collapsed from above JPY135 to below JPY110 over the same period.
The reason we raise this issue is a simple one. So far it is arguable that nothing material has emerged to upset the post November trends towards JPY weakness/Nikkei 225 strength (even now the 10-year JGB yield is only a little higher to where it was on November 15th) . However, it is not immediately apparent what would happen if the move out of JGBs became rather more disorderly. Would this lead to a rapid weakening of the JPY or would it see a strengthening of the currency as it did in 2003 and 1998? Let us hope that the BOJ and the MOF make sure that we don’t need to find out.
